Saturday, October 11, 2008

Causes of the Present Crisis

This is the great Jim Rogers, legendary investor (and Ron Paul supporter) talking about our current economic mess a year ago. Think of him as a libertarian George Soros. Notice he saw it all coming, and explained why (in part) it would happen. If you know the cause, you can predict the effect.

As to the cause of the banking crisis, please find the time to read this paper, "Anatomy of a Train Wreck: Causes of the Mortgage Meltdown," but Stan J. Liebowitz. Prof. Liebowitz has been doing research on subjects like regulation and the economics of property rights for almost three decades. (Hat tip to Thomas DiLorenzo.) The tale he tells so methodically will make you very angry, once you grasp what he is saying. At least it should.

He points out two extraordinary features of the mortgage meldown. As in the Great Depression, we suddenly had an extraordinary number of mortgage defaults. But the Depression wave of defaults happened in an environment of horrific unemployment and falling profits. This time, these other things were not happening. Why the sudden plague of defaults, sufficiently awful to ruin banks and begin to pull the rest of the economy down with it? Why did this happen?

The other feature is at least as remarkable as this, and at least as worthy of an explanation. The plague of defaults wasn't (at least, not yet) poor people who were suckered into sub-prime loans that they couldn't afford the pay. The sub-prime borrowers did not default any more often than the prime ones. The real problem was elsewhere: believe it or not, the mortgages that defaulted at disproportionate rates were the variable rate ones, both sub-prime and prime ones. And this happened in spite of the fact that variable rate loans have lower interest rates than fixed rate loans. (They have to, or borrowers would not accept the greater uncertainty of variable rates. That's how markets work.) Again, this is weird. Why did it happen?

The original cause of it all, Liebowitz argues, was a collection of regulators, bureaucrats, and politicians who decided in the early nineties that a lot more Americans should own their own homes. Renting bad, owning good. Soon, every branch of the government aggressively pursued policies designed to pressure banks to designing "innovative" and "flexible" (their words) underwriting standards, designed to change Mr. Potter into George Bailey by means of various sorts of threats and intimidation (we are talking about the government, after all).

The new policy was a spectacular success: rates of ownership versus renting increased dramatically. But there was a further result as well. Every Econ 101 student knows that increases in demand ceteris paribus result in -- what, class? That's right: higher prices. Housing prices rose, and continued to rise. This brought in the speculators. "Flipping" became so common it was the subject of more than one TV series. In 2005, speculation accounted for almost one third of all home purchases. That was not a good thing.

Price bubbles inflated by government and speculation cannot inflate forever, and when this one exploded, speculators were left with houses they could no longer unload at a price higher than they paid for it. There was only one thing to do. Default.

This explains, Liebowitz argues, the oddity of the variable rate mortgages being the ones that melted down. The variability of those interest rates is scary to someone who intends to live in their house for decades. But to a speculator it makes no difference, because they intended to unload the property before rates can rise very much, and the fact that these mortgages had lower interest rates than ones with fixed rates makes them very attractive. When the inevitable happened these mortgages melted down at such massive numbers they threatened all of us.

The cause of this disaster was not "greed," except in the Pickwickian sense in which the cause of plane crashes is gravity. The question, is why did gravity cause this housing market to go insane and crash into a wall, and not the others?

Nor, as Liebowitz tells it, was the cause the disaster the "predatory lenders" who lured poor people in over their heads. Those borrowers are so far not part of the problem. And the problem certainly was not, as Obama keeps claiming, deregulation. It was reregulation.

All of the talk I've heard out there by non-economists is based on the assumption that the problem absolutely must be that there weren't more regulations on private, market agents. They must be thinking that regulations are rules that prevent guys from putting carcinogens in your orange juice. If some harm was done, it must have been some private citzen who did it, and some clever person should have thought up a rule against that particular sort of harm. We see here that, unfortunately, there are plenty of regulations that are not like that at all. Some regulations create powerful entities like Fannie Mae, Freddie Mac, and the Federal Reserve Bank, and direct them to bring about Utopia.

The "failed economic policy," to use another of Obama's tropes, that caused this crisis was the idea that we can use government coercion, not to stop people from violating the rights of others, but to force the market to produce some positive result we want, and only the result that we want. This is true arrogance, the hybris that the gods punish with madness and destruction.

Actually, there is a sort of regulation that we probably do need. These would be regulations that restrict the powers of these government-created entities. These entities were among the tools the government was using to force the market to produce home ownership Utopia. Today there are few real limits to their power. The Chair of the Fed is a monetary dictator. There were probably more checks and balances on the Tsar of All the Russias than there are on Ben Bernanke. But the people who are talking today about reregulating are not talking about reigning these people in. They are talking about giving them, and others who caused this disaster, even more unchecked power.

9 comments:

The Greek letter upsilon can be transliterated either with a y or a u. The upper case letter looks like a y, and the lower case like a u. It was probably pronounced like something in between, like the German u-umlaut.

Greed had nothing to do with it? How about all the sharp guys who devised bundling up sub-prime mortgages and selling them for a quick buck, knowing they wouldn't be holding them when the shit hit the fan, and the Wall Sreet firms that bought them or speculated on them on he same operating principle.

In the first place, I am not saying greed had nothing to do with it. Gravity has something to do with airplane crashes, but it is an uninformative explanation. Secondly, I am not sure what is wrong with selling a mortgage to a second party, as long as there is no fraud involved and they know what they are getting. Finally, you are describing one of the many dominoes that fell as a consequence of the government's manipulations of the housing market for its own ends. The reselling of debts would not have been a problem, if not for that. If we are going to fix the system, we need to look at fundamental problems, the thing that turned factors that would have been no problem into very big ones. That is what must been changed.

The house flipping had a positive effect on contractors who were hiring people to fix up the homes for resale and of course they were using alot of skilled and unskilled (Mexican?) labor. The point being that every time a low interest, 1 year mortgage that was taken out by a house contractor was written, the banks, local governments, title co's etc. were also making fees, which was perfectly legit laissez faire economics.

As you pointed out, the home owner who got the next variable mortgaage on the house may have been surprised by the sudden rate increase which was being fed back into a wall street portfolio. Also many speculators were stuck with inventories of houses they could not sell. Therefore the normal cyclical downturn in the economy in the last 2 or 3 years accelerated the default rate.

Yes, much of what is done as a result of one of these government-generated booms is perfectly legitimate productive activity. Lots of houses were built or improved. It wasn't all pure speculation. These people were doing what normal economic agents do, in response to market signals. The problem with that (which I didn't go into above) is that these signals were distorted by government intervention. If the people of America had been responding to signals based on the real relative costs of everything, they would have put less into building or improving houses and more into other things. I notice, in what I have read about it, that the housing rental sector was being seriously damaged during growth of the housing bubble. Part of what we are seeing now is a readjustment in light of real costs, which are painfully being brought home to us. Of course, this will stop as soon as the government succeeds in masking the real costs again.

I agree that the government felt they could get "more bang for the buck" by invigorating the housing industry throuigh relaxed mortage lending but they were actually engaging in the socialist tactic of a planned economy. As far as minorities go, the 90's Welfare to Work Program was social engineering to get more minorities into the work force which translated into more home ownership.

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Who Am I?

In 2016 I retired from teaching philosophy at the University of Wisconsin after working for 40 years at 7 different colleges and universities. At present, I live in Reno NV and Plumas County CA and am working on a book on the philosophy of Henry David Thoreau.